The Kendall Rule Explained

The Kendall Rule

“As long as excess reserves persist, with IOR, in amounts necessary to facilitate Federal Reserve control of the price of interest, the trend for the minimum price of gold is determinative by its average price over the duration of debt.”

There is no doubt that the great Ph.D QE monetary experiment, instigated by the Bernanke Fed after the 2008 crisis and exported to global central banks, has confounded traditional economics.  I am still searching for the great classical economists’—who centuries ago laid the economic foundation for free markets and productive growth based upon stable money and low taxes—discussion of the existence and benefit of negative interest rates.  Even more so, their prediction of the end of growth and secular stagnation.  We have yet to confront the aftermath of the liquidity flood wreckage.  At some point we will have to sort through the mess to regain our economic footing.  Indeed, we are still in the punchbowl phase of $3.6 trillion of new dollar liquidity, conjured out of nothing, that is sloshing through the economy in the form of  capital misallocation, economic distortion, excess reserves, financialization, manipulated interest rates, and perpetually rising market indices amid stagnated growth.  A further $8.7 trillion since 2008 in other major central bank (ECB, BOJ, PBOC) liquidity floods the global economy.  Combined, the four major central banks have created $12.3 trillion of liquidity since 2008.  In our contagion connected, instantaneous fiat financial system, the global populace are all in this together.

The Fed now desires to un-spike the punchbowl that the crony, connected, and powerful one percent have binged on non-stop for the last nine years.  The Fed is giving forward guidance that sometime in the future—provided nothing goes financially wrong in the interim—it will begin shrinking its balance sheet along with excess reserves.  The U.S. is not a closed economy and the dollar is the world’s reserve currency.  The Fed will export its normalization process to the other major central banks.  The PBOC links the yuan to the dollar, so it will directly import the Fed’s normalization.  The BOJ and ECB are currently expanding their balance sheets at $200 billion a month.  This is a massive disconnect that will cause forex turmoil if the major CBs do not align their policy. 

To understand the chaos of the great QE liquidity flood experiment, requires understanding the gold signal in a floating fiat world.  There is always an optimum dollar price of gold (POG) that balances creditors and debtors.  Under a gold standard, the optimum POG is fixed.  In a fiat world, it is constantly changing.  The supply of base money is in equilibrium with the demand for base money at the optimum POG.  When the Fed stabilizes the optimum POG at a set dollar POG, it stabilizes the price level.  There is no inflation or deflation.  When the optimum POG changes, the price level will also change to adjust to the new optimum POG.  The change in the optimum POG is instant in tandem with the constantly changing spot price of gold in our fiat world.  The price level takes years to adjust to a new optimum POG.  Contracts, wages, and debt terms have to unwind for the price level to adjust.  I term the amount of time it takes the price level to adjust to a new optimum POG as the duration of debt (in the Kendall Rule).  Developed economies with a history of stable currency have a longer duration of debt than emerging economies with a history of unstable currency.  A gold standard defines the optimum POG at a set currency value (parity point) and the price level remains stable about the parity point. This is how gold standards, when they strictly adhered to a defined currency POG, worked for centuries and eliminated inflation and deflation.  Gold’s value is stable, so a currency linked to gold becomes equally stable in value.      

When the Bretton Woods international gold standard ended in 1971, the Fed no longer maintained the supply of base money in equilibrium with demand at the parity point of $35/oz.  The POG rose correspondingly, which reflected a change in the price level.  Gold went from $35/oz to $850 and settled at $350/oz.  During the Great Moderation period the price level adjusted to the new optimum gold price of $350/0z.  The optimum POG rose by a factor of 10, and the price level eventually adjusted by a factor of 10 over a longer period of time—the duration of debt.

Fast forward to 2008.  From the beginning of Bernanke’s Fed Chair term in 2006, the optimum POG began an upward trend from the equilibrium point of $350/oz.  Bernanke has no understanding of gold so the market naturally began to selloff the dollar.  Leading up to the 2008 crisis, the POG was $1000, though the optimum level was still around $450/oz.  With the onset of the 2008 crisis, gold sold off to $750.  There was global demand for the dollar amid frozen lending.  When base money demand exceeds supply the value of the dollar becomes more valuable relative to gold.  This reversed when the Fed began QE.  The flood of QE base money supply exceeded demand and the POG rose.  By September 2011 after multiple iterations of QE, the POG was at $1900.  Gold at $1900 was discounting that banks would create loans against the excess liquidity created by QE, a repeat of the inflationary 70s.

In tandem with the onset of QE, the Fed began paying interest on reserves (IOR).  The Fed drove the funds rate to the zero bound and IOR was .25 percent.  When gold reached $1900 in September 2011, there were $1.55 trillion of excess reserves.  Depository institutions were holding the excess reserves for IOR instead of lending against them.  In essence excess reserves are liquidity that depository institutions lock out of the economy in return for Fed interest payments.  The POG began to fall from $1900 to reflect excess reserves locked out of the economy.  Near the end of QE in October 2014, there were $2.7 trillion of excess reserves.

Why were banks willing to hold excess reserves for a .25 percent return instead of lending against them for a higher return?  A couple of factors are now apparent.  U.S. subsidiaries of foreign banks hold a significant portion of excess reserves, probably in response to conditions in the EU.  Large U.S. banks hold the majority of the remaining.  Congress gave the Fed new regulatory power after the 2008 crisis.  One can assume that after the Fed bailed out the TBTFs, they are holding excess reserves in compliance with the Fed’s regulatory wishes. 

It became apparent to me in June 2015 what was happening.  When most analysts were predicting gold would fall to $800/oz or lower, I realized that gold would not fall much below $1100/oz–the intersection of the POG with the duration of debt.  With excess reserves the Fed ceded its control over the equilibrium between base money supply and demand.  Any excess supply would flow to excess reserves and excess reserves would meet any excess demand.  A base money equilibrium would establish itself beyond the Fed’s control at the duration of debt.  The POG would fall to the duration of debt level then reach equilibrium.  The POG has been tracking the duration of debt level since July 2015.  There were initial oscillations of the POG about the duration of debt level that have now dampened out.  The POG is acting in accordance with the Kendall Rule. 

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2 Comments

  1. Anonynymous

    Thanks for the article. Where do you get the duration of debt value? I’ve never heard of it before.

    Reply
    1. Michael Kendall (Post author)

      It’s a bit of a wag derived from understanding gold and gold standards, but I think it’s accurate enough.

      Reply

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